Brace for Explosive Gains in Japan Stocks as Yen Slumps

Japanese stocks have rallied over five percent in the past week on the prospect of the opposition Liberal Democratic Party (LDP) - a proponent of unlimited monetary easing – winning a majority in the December elections, and analysts forecast bumper gains for the country's equity markets if this scenario plays out.

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Nicholas Smith, Japan strategist at CLSA, who believes the LDP will form an alliance to win the upcoming election, said the opposition party will unleash aggressive monetary stimulus that will push the yen down further, and drive Japanese equities higher in the next three months.

"Recent gains in Japanese stocks are absolutely sustainable. I see 20 percent upside for the Topix ver the next three months," Smith said, adding that he forecasts dollar-yen will hit 85 in the second half of 2013.

Japanese corporates, in particular exporters, have been under pressure from persistent strength in the yen, which has made their products less attractive in the global market. A weakening in the currency provides a significant boost to their competitiveness.

Last week, Shinzo Abe, head of the LDP who is seen as the leading contender to become the next prime minister, called for unlimited monetary easing to spur inflation. The current inflation target is 1 percent, but Abe wants to raise it to 2-3 percent. The yen has fallen over 2 percent since his comments on November 14.

"(Shinzo) Abe's focus is on two things — aggressive monetary and fiscal stimulus. He made clear that the Bank of Japan will bend to his will or he will rewrite the BOJ (Bank of Japan) Law to let him fire them," Smith wrote in a report.

Each 1 yen move lower could lead to gains of around 6 percent for the Nikkei 225, forecasts Ben Collette, head of Japan equities, at Louis Capital Markets.

John Vail, chief global strategist at Nikki Asset Management, who is also positive on the outlook for Japanese stocks over the next 3-6 months on expectations of further weakness in yen, agrees the Bank of Japan will commit to unlimited monetary easing.

"The BOJ will come under increasing pressure, and will comply with pressure adopting a 2 percent inflation target," he said. "When you are seeking an inflation target, it implies unlimited easing."

The central bank will step up its purchases of risk assets including equity exchange-traded funds, Vail added, which will provide additional upward momentum for stocks.

Bank of Japan governor Masaaki Shirakawa, who has been criticized for not easing monetary policy aggressively enough, is expected to step down when his term expires next April. His replacement, Smith said, will be selected for their "willingness to print money."

Smith and Vail are not alone in their enthusiasm towards Japanese equities. Michael Harnett, chief investment strategist at Bank of America Merill Lynch believes if the LDP were to gain control, it would "significantly" alter the landscape of Japanese politics and change monetary policy into one that's more pro-growth and inflationary.

"We believe this would be yen negative, equity positive and Japanese government bond negative," he said.

However, Mark Matthews, head of Asia research at Bank Julius Baer is skeptical that the opposition party will be able to undermine the independence of the country's central bank and dictate the direction of monetary policy.

"It's very nice to hear the LDP talking about forcing the BOJ to buy bonds, but you can't force them. The BOJ's independence is enshrined in the constitution. So just because the LDP says it's going to force the central bank to do things it doesn't mean it actually can," he told CNBC Asia's "Cash Flow".